The Myths of Momentum Investing

Conventional Assumptions About Momentum Investing Debunked: Specific Company Attributes and Higher Risk Account for Success

SagiJacobWhile positive company returns are a mainstay for building equity portfolios, some investors focus even more intensely on harnessing the potential benefits of momentum—or an increasing pattern in recent stock performance—to construct portfolios that earn above-average returns. And for decades, many researchers and investment managers have believed that profitable yields from such momentum-based strategies are largely the result of market inefficiencies or irrational investor behavior.

However, this conventional wisdom about momentum investing just didn’t totally add up for Jacob Sagi, who recently joined the Owen faculty as associate professor of finance from the Haas School of Business at the University of California, Berkeley.  “Such conclusions have been based largely on overly simplified models which—despite more than a decade of momentum-related studies—fail to identify some sensible economic attributes that could directly contribute to increased returns,” said Sagi. Until now, that is.

PHOTO: Jacob Sagi, Associate Professor of Management

In a groundbreaking study published recently in the Journal of Financial Economics, Sagi—in partnership with Mark Seasholes, assistant professor of finance at Berkeley—takes a closer look at momentum-investing assumptions and provides a new framework for understanding momentum profits and for enhancing momentum strategies.  “Our results,” said Sagi, “indicate that the success of momentum strategies is not about market inefficiency and low risk—but appears to be tied directly to specific attributes of a company that affect the way its risk varies over time.”

Behind the mysteries of momentum

At its core, momentum investing involves the buying of stocks or other securities with consistently high historical returns, over the last three to twelve months, and selling those that have had poor returns over the same period. While it’s been around for decades, this type of investing became quite popular in the 1990s, spawning several high-priced newsletters that compiled records of impressivemomentum-driven returns. Among the most outspoken proponents of momentum investing was Richard Driehaus, founder of Driehaus Capital Management.  Driehaus made momentum investing principles the core strategy he used to run his funds, believing that “far more money is made buying high and selling at even higher prices.”

Similarly, researchers have also paid increasing attention to the nuances of momentum investment strategies, aiming to quantify and improve their profitability.  But, for Sagi and his coauthor, the existing literature fell short when it came to pinpointing the economic rationale behind the success of momentum investment strategies. 

Building a model and testing the data

Sagi and Seasholes felt that a critical first step to understanding this complex phenomenon was to model a single, representative company using basic attributes such as volatile revenues, operating costs and growth options.  The company’s value and risk profile was determined by assuming that its managers emphasized the maximization of shareholder value in operating the firm and exercising its growth option.  

Applying this model, Sagi and Seasholes calculated the sensitivity of the company’s performance to various parameters. What they discovered was that certain firms exhibited a positive relationship between past returns and future performance, or momentum in the firm’s returns, among those firms with high revenue growth volatility, low cost of goods sold and high market-to-book value. They then used the same approach to simultaneously simulate the performance of many companies with different characteristics, and used the results to construct momentum investment portfolios. Their goal was to see whether momentum profits in an ‘economy’ populated by their model firms could mimic actual equivalent data from all publicly listed firms between 1963 and 2004.

The results from this analysis were dramatically clear. The ‘model economy,’ made up of firms that rationally maximized shareholder value, was able to produce momentum profits that were remarkably in line with empirically measured profits (something that no other study had managed to do). Further, momentum profits were far higher during times of overall market expansion in both the model and the real economy. Portfolios comprised of companies with high market-to-book values—considered to be a reflection of strong growth options—significantly outperformed those formed from low market-to-book companies. According to the study, high market-to-book companies had an average return of 3.44 percent per quarter, while low market-to-book firms had an average return of 1.01 percent per quarter—a difference of about 10 percent annually. In addition, companies with low cost of goods sold demonstrated enhanced yearly momentum profits that were between two and nine percent higher than companies with high cost. Finally, companies with high revenue volatility produced momentum profits between six and 14 percent higher per year than low revenue volatility firms.

Taken together, these advanced momentum strategies produced profits that outperformed traditional investment strategies by approximately five percent per year. 

Enhanced momentum strategies for greater returns

“The bottom line,” said Sagi, “is that there is now theoretical rationale and empirical evidence for obtaining higher return from momentum strategies restricted to firms having certain characteristics. Momentum profits tend to be higher when the portfolio consists only of high revenue-volatility, low-cost and high book-to-market companies.” 

Sagi also believes that this research demonstrates that the profitability of momentum strategies may be associated with higher risk, which flies in the face of more than 15 years of previous research.  “Our model economy was made up of firms doing economically rational things in a rational market, and the study’s results point toward the possibility that momentum may not be giving investors high return with low risk after all,” he said.

The results of Sagi’s research shed new li